Derivative markets and instruments

Explanation As opposed to forward contracts, futures contracts are traded over an organized exchange and are standardized in size, maturity, quality of deliverable, etc.. Explanation For

Derivative Markets and Instruments Test ID: 7697683

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Which of the following statements about futures and the clearinghouse is least accurate? The clearinghouse:

has defaulted on one half of one percent of futures trades.

requires the daily settlement of all margin accounts

guarantees that traders in the futures market will honor their obligations

Explanation

In the history of U.S futures trading, the clearinghouse has never defaulted

The clearinghouse guarantees that traders in the futures market will honor their obligations The clearinghouse does this by

splitting each trade once it is made and acting as the opposite side of each position The clearinghouse acts as the buyer to

every seller and the seller to every buyer By doing this, the clearinghouse allows either side of the trade to reverse positions later

without having to contact the other side of the initial trade This allows traders to enter the market knowing that they will be able

to reverse their position any time that they want Traders are also freed from having to worry about the other side of the trade

defaulting, since the other side of their trade is now the clearinghouse

To safeguard the clearinghouse, the exchange requires traders to post margin and settle their accounts on a daily basis

Which of the following is a difference between futures and forward contracts? Futures contracts are:

larger than forward contracts.

over-the-counter instruments

standardized

Explanation

As opposed to forward contracts, futures contracts are traded over an organized exchange and are standardized in size, maturity, quality of

deliverable, etc

If the margin balance in a futures account with a long position goes below the maintenance margin amount:

a deposit is required to return the account margin to the initial margin level.

a deposit is required which will bring the account to the maintenance margin level

a margin deposit equal to the maintenance margin is required within two business days

Explanation

Once account margin (based on the daily settlement price) falls below the maintenance margin level, it must be returned to the

initial margin level, regardless of subsequent price changes

Question #4 of 60 Question ID: 415742

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The party to a forward contract that is obligated to purchase the asset is called the:

long.

short

receiver

Explanation

The long in a forward contract is obligated to buy the asset (in a deliverable contract) The term receiver is used with swaps

In a plain vanilla interest rate swap:

one party pays a floating rate and the other pays a fixed rate, both based on the notional

amount.

each party pays a fixed rate of interest on a notional amount

payments equal to the notional principal amount are exchanged at the initiation of the swap

Explanation

A plain vanilla swap is a fixed-for-floating swap

Which of the following relationships between arbitrage and market efficiency is least accurate?

Investors acting on arbitrage opportunities help keep markets efficient.

Market efficiency refers to the low cost of trading derivatives because of the lower expense to

traders

The concept of rationally priced financial instruments preventing arbitrage opportunities is the basis

behind the no-arbitrage principle

Explanation

Market efficiency is achieved when all relevant information is reflected in asset prices, and does not refer to the cost of trading

One necessary criterion for market efficiency is rapid adjustment of market values to new information Arbitrage, trading on a

price difference between identical assets, causes changes in demand for and supply of the assets that tends to eliminate the

pricing difference

A 4 percent Treasury bond has 2.5 years to maturity Spot rates are as follows:

6 month 1 year 1.5 years 2 years 2.5 years

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The note is currently selling for $976 Determine the arbitrage profit, if any, that is possible

$19.22.

$37.63

$43.22

Explanation

Typically, forward commitments are made with respect to all the following EXCEPT:

inflation.

equities

bonds

Explanation

Forward commitments can be customized and could be written on some measure of inflation, but typically they are not The

volume of forward commitments, including forward contracts and futures contracts, on bonds, equities, and interest rates is in the

many billions of dollars

Which of the following is least likely a characteristic of futures contracts? Futures contracts:

are backed by the clearinghouse.

require weekly settlement of gains and losses

are traded in an active secondary market

Explanation

Futures contracts require daily settlement of gains and losses The other statements are accurate.

The clearinghouse, in U.S futures markets is least likely to:

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guarantee performance of futures contract obligations.

choose which assets will have futures contracts

act as a counterparty in futures contracts

Explanation

The exchange decides which contracts will be traded and their specifications The clearinghouse acts as the counterparty to

every contract and guarantees performance

Which of the following statements about forward contracts is least accurate?

The long promises to purchase the asset.

Both parties to a forward contract have potential default risk

A forward contract can be exercised at any time

Explanation

Forward contracts typically require a purchase/sale of the asset on the expiration/delivery date specified in the contract The

other statements are true

Which of the following is the best interpretation of the no-arbitrage principle?

The information flow is quick in the financial market.

There is no free money

There is no way you can find an opportunity to make a profit

Explanation

An arbitrage opportunity is the chance to make a riskless profit with no investment In essence, finding an arbitrage opportunity is like

finding free money As you recall, in arbitrage, you observe two identical assets with different prices Your immediate response should be

to buy the cheaper one and sell the expensive one short You can then deliver the cheap one to cover your short position Once you take

the initial arbitrage position, your arbitrage profit is locked in The no-investment statement referenced in the text refers to the assumption

that when you short the expensive asset, you will be given access to the cash created by the short sale With this cash, you now have the

money to buy the cheaper asset The no-investment assumption means that the first person to observe a market pricing error will have the

financial resources to correct the pricing error instantaneously all by themselves

Which of the following statements regarding futures and forward contracts is least accurate?

Futures contracts are highly standardized.

Forwards require no cash transactions until the delivery date, while futures require a margin deposit when

the position is opened

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Both forward contracts and futures contracts trade on organized exchanges

Explanation

Forward contracts are custom-tailored contracts and are not exchange traded while futures contracts are standardized and are traded on

an organized exchange

Some forward contracts are termed cash settlement contracts This means:

either the long or the short in the forward contract will make a cash payment at contract

expiration and the asset is not delivered.

at contract expiration, the long can buy the asset from the short or pay the difference between the

market price of the asset and the contract price

at settlement, the long purchases the asset from the short for cash

Explanation

In a cash settlement forward contract there is a cash payment at settlement by either the long or the short depending on whether

the market price of the asset is below or above the contract price at expiration The underlying asset is not purchased or sold at

settlement

A financial instrument that has payoffs based on the price of an underlying physical or financial asset is a(n):

derivative security.

future

option

Explanation

Options and futures are examples of types of derivative securities

An agreement that gives the holder the right, but not the obligation, to sell an asset at a specified price on a specific future date is

a:

put option.

call option

swap

Explanation

A put option gives the holder the right to sell an asset at a specified price on a specific future date A call option gives the holder

the right to buy an asset at a specified price on a specific future date A swap is an obligation to both parties

Question #17 of 60 Question ID: 415804

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Standardized futures contracts are an aid to increased market liquidity because:

standardization results in less trading activity.

standardization of the futures contract stabilizes the market price of the underlying commodity

uniformity of the contract terms broadens the market for the futures by appealing to a greater

number of traders

Explanation

Although a forward may have value to someone other than the original counterparties, the non-standardized terms limit the level

of interest, hence its marketability and liquidity The standardized terms of a future give it far more flexibility to traders, giving rise

to a strong secondary market and greater liquidity

Which of the following statements about arbitrage is NOT correct

No investment is required when engaging in arbitrage.

If an arbitrage opportunity exists, making a profit without risk is possible

Arbitrage can cause markets to be less efficient

Explanation

Arbitrage is defined as the existence of riskless profit without investment and involves selling an asset and simultaneously buying

the same asset for a lower price Since the trades cancel each other, no investment is required Because it is done

simultaneously, a profit is guaranteed, making the transaction risk free Arbitrage actually helps make markets more efficient

because price discrepancies are immediately eradicated by the actions of arbitrageurs

Default risk in a forward contract:

only applies to the short, who must make the cash payment at settlement.

only applies to the long, and is the probability that the short can not acquire the asset for delivery

is the risk to either party that the other party will not fulfill their contractual obligation

Explanation

Default risk in forward contracts is the risk to either party that the other party will not perform, whether that means pay cash or

deliver the asset

Which of the following statements about arbitrage opportunities is CORRECT?

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Engaging in arbitrage requires a large amount of capital for the investment.

When an opportunity exists to profit from arbitrage, it usually lasts for several trading days

Pricing errors in securities are instantaneously corrected by the first arbitrageur to recognize them

Explanation

Arbitrage is the opportunity to trade in identical assets that are momentarily selling for different prices Arbitrageurs act quickly to

make a riskless profit, causing the price discrepancy to be instantaneously corrected No capital is required, because opposite

trades are made simultaneously

A legally binding promise to buy 140 oz of gold two months from now at a price agreed upon today is a(n):

take-or-pay contract.

hedge

forward commitment

Explanation

It is a forward commitment; it may be used to hedge or may be used to speculate on the price of gold in two months

The settlement price for a futures contract is:

an average of the trade prices during the 'closing period'.

the price of the last trade of a futures contract at the end of the trading day

the price of the asset in the future for all trades made in the same day

Explanation

The margin adjustments are made based on the settlement price, which is calculated as the average trade price over a specific

closing period at the end of the trading day The length of the closing period is set by the exchange

Which of the following is a common criticism of derivatives?

Derivatives are likened to gambling.

Derivatives are too illiquid

Fees for derivatives transactions are relatively high

Explanation

Derivatives are often likened to gambling by those unfamiliar with the benefits of options markets and how derivatives are used

Question #24 of 60 Question ID: 415853

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A European option can be exercised by:

its owner, only at the expiration of the contract.

its owner, anytime during the term of the contract

either party, at contract expiration

Explanation

A European option can be exercised by its owner only at contract expiration

A derivative security:

has a value based on stock prices.

has a value based on another security or index

has no default risk

Explanation

This is the definition of a derivative security Those based on stock prices are equity derivatives

An analyst determines that a portfolio with a 35% weight in Investment P and a 65% weight in Investment Q will have a standard

deviation of returns equal to zero

Investment P has an expected return of 8%

Investment Q has a standard deviation of returns of 7.1% and a covariance with the market of 0.0029

The risk-free rate is 5% and the market risk premium is 7%

If no arbitrage opportunities are available, the expected rate of return on the combined portfolio is closest to:

6%.

7%

5%

Explanation

If the no-arbitrage condition is met, a riskless portfolio (a portfolio with zero standard deviation of returns) will yield the risk-free

rate of return

Regarding buyers and sellers of put and call options, which of the following statements concerning the resulting option position is

most accurate? The buyer of a:

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call option is taking a long position and the buyer of a put option is taking a short position.

put option is taking a short position and the seller of a call option is taking a short position

call option is taking a long position while the seller of a put is taking a short position

Explanation

The buyers of both puts and calls are taking long positions in the options contracts (but the buyer of a put is establishing a

potentially short exposure to the underlying), while writers (sellers) of each are taking short positions in the options contracts

Sally Ferguson, CFA, is a hedge fund manager Ferguson utilizes both futures and forward contracts in the fund she manages

Ferguson makes the following statements about futures and forward contracts:

Statement 1: A futures contract is an exchange traded instrument with standardized features

Statement 2: Forward contracts are marked to market on a daily basis to reduce credit risk to both counterparties

Are Ferguson's statements accurate?

Both of these statements are accurate.

Neither of these statements is accurate

Only one of these statements is accurate

Explanation

Statement 1 is correct A futures contract is a standardized instrument that is traded on an exchange, unlike a forward contract

which is a customized transaction Statement 2 is incorrect A forward contract is not marked to market

Which of the following represents a long position in an option?

Writing a call option.

Buying a put option

Writing a put option

Explanation

A long position is always the buying position Remember that the buyer of an option is said to have gone long the position, while

the writer (seller) of the option is said to have gone short the position

Any rational quoted price for a financial instrument should:

provide no opportunity for arbitrage.

provide an opportunity for investors to make a profit

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be low enough for most investors to afford

Explanation

Since any observed pricing errors will be instantaneously corrected by the first person to observe them, any quoted price must be free of all

known errors This is the basis behind the text's no-arbitrage principle, which states that any rational price for a financial instrument must

exclude arbitrage opportunities The no-arbitrage opportunity assumption is the basic requirement for rational prices in the financial

markets This means that markets and prices are efficient That is, all relevant information is impounded in the asset's price With

arbitrage and efficient markets, you can create the option and futures pricing models presented in the text

The process that ensures that two securities positions with identical future payoffs, regardless of future events, will have the

same price is called:

arbitrage.

exchange parity

the law of one price

Explanation

If two securities have identical payoffs regardless of events, the process of arbitrage will move prices toward equality

Arbitrageurs will buy the lower priced position and sell the higher priced position, for an immediate profit without any future

liability The law of one price (for securities with identical payoffs) is not a process; it is 'enforced' by arbitrage

MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the previous period The consensus

expectation of financial analysts had been an increase in EPS of 10% After the earnings announcement the value of MBT

common stock increased each day for the next five trading days, as analysts and investors gradually reacted to the better than

expected news This gradual change in the value of the stock is an example of:

speculation.

efficient markets

inefficient markets

Explanation

A critical element of efficient markets is that asset prices respond immediately to any new information that will affect their value

Large numbers of traders responding in similar fashion to the new information will create a temporary imbalance in supply and

demand, and this will adjust asset market values

Financial derivatives contribute to market completeness by allowing traders to do all of the following EXCEPT:

engage in high risk speculation.